Australia has enjoyed a robust economic performance despite the commodity price and mining investment bust. The moderate impact of the large shocks since 2011 reflects prompt monetary easing, a flexible exchange rate acting as a shock absorber, export orientation to the dynamic Asia region, flexible labor markets, relatively high population growth, and strong institutions. Nevertheless, Australia has also been confronted with symptoms of the 'new mediocre' since the Global Financial Crisis, including a downshift in average GDP growth. And with declining interest rates, already high house prices and household debt ratios have started to rise again.

Abstract

Australia has enjoyed a robust economic performance despite the commodity price and mining investment bust. The moderate impact of the large shocks since 2011 reflects prompt monetary easing, a flexible exchange rate acting as a shock absorber, export orientation to the dynamic Asia region, flexible labor markets, relatively high population growth, and strong institutions. Nevertheless, Australia has also been confronted with symptoms of the 'new mediocre' since the Global Financial Crisis, including a downshift in average GDP growth. And with declining interest rates, already high house prices and household debt ratios have started to rise again.

Context

1. Australia’s economic performance has been robust in comparison to other advanced economies despite the commodity price and mining investment bust. Growth has remained above 2 percent (annual rate) and increases in unemployment have been small. The moderate impact of the large shocks since 2011 reflects prompt monetary easing, a flexible exchange rate acting as a shock absorber, export orientation to the dynamic Asia region, relatively high labor force and population growth, and flexible labor markets. Another reason is the relatively small size of the commodity sector and continued strong mining export performance (Annex I: “Four Years After the Bust …”). In this setting, Australia’s long expansion without a recession has continued uninterrupted for 25 years.

A01ufig1

Average Annual Real GDP Growth (2009-15)

Citation: IMF Staff Country Reports 2017, 042; 10.5089/9781475575835.002.A001

Source: IMF, World Economic Outlook database.

2. Still, Australia has been confronted with symptoms of the “new mediocre.” The economy has experienced a slowdown since the global financial crisis (GFC), with average GDP growth about 0.8 percent lower (annual rate), which is indicative of lower potential output growth. As elsewhere, the adjustment to the shocks has been drawn out, and growth has fallen short of expectations in 2014 and early 2015, partly from weaker-than-expected partner country growth and partly from domestic demand weakness. In particular, growth in non-mining business investment has been slow despite declines in real interest rates and real exchange rate depreciation. At the same time, underemployment and long-term unemployment have been higher, while nominal wage growth has been low and inflation has fallen below target.

Real GDP

Citation: IMF Staff Country Reports 2017, 042; 10.5089/9781475575835.002.A001

Sources: Haver Analytics and IMF staff calculations.1/ Counterfactual is based on pre-GFC average growth (2003-07).

3. Housing-related and external macro-financial vulnerabilities are a concern. Real house prices and household debt ratios rose to high levels in tandem during the country’s economic boom of the 1990s and 2000s. While stabilizing after the global financial crisis, both house prices and household debt ratios have picked up again recently. The main concern is the large housing exposure (over 50 percent of total assets) of Australia’s highly concentrated banking system. On the external side, Australia has had long-running current account deficits and a relatively large net external liability position. Much of the related risks focus on the funding of Australian banks because they rely heavily on international wholesale markets.

A01ufig3

Real House Prices

(1995=100)

Citation: IMF Staff Country Reports 2017, 042; 10.5089/9781475575835.002.A001

Sources: Haver; and IMF staff calculations.

Recent Developments, Outlook and Risks

A. Developments over the Past Year

4. Australia’s recovery advanced with a pickup in activity from mid-2015, but underlying demand growth remained closer to trend. Growth (at annual rates) increased to over 3 percent from mid-2015—above current potential output growth estimates of 2¾ percent—driven by higher government spending, LNG export capacity coming on stream, strong services export growth, and buoyant residential investment.1 That said, private business investment outside mining has remained more subdued than expected. And with the growth rebalancing toward non-mining activity, activity in states where such activity dominates has been buoyant, and disparities in economic performance between non-mining and mining states have widened. With hindsight, some of the growth pickup in early 2016 reflected one-off level increases in demand, particularly in government spending. Consequently, real GDP unexpectedly contracted by 2 percent annualized in 2016Q3 when these level effects wore off, with temporary, weather-related weakness in residential investment spending also contributing. The strength of underlying growth in aggregate demand, however, does not appear to have changed.

A01ufig4

State Final Demand

(Contributions to annual growth)

Citation: IMF Staff Country Reports 2017, 042; 10.5089/9781475575835.002.A001

Sources: Australian Bureau of Statistics; and Haver.

5. Labor market conditions have improved although the fall in the unemployment rate likely overstates the improvement in labor markets. Employment picked up with overall activity, and unemployment has decreased from its recent peak. Still, the underemployment rate—defined as the share of employed persons in the labor force seeking to work more hours—has remained almost 2 percentage points above average (7 percent of the active labor force over the past 20 years). Some 80 percent of the jobs created over the past year or so have been part-time jobs.2 At the same time, the share of long-term unemployment has remained above average. As of mid-2016, IMF Staff estimates the output gap at 1.7 percent and the unemployment rate gap at 0.5 percent (about 1¼ percent at the peak).

A01ufig5

Unemployment and Underemployment Rate

(%)

Citation: IMF Staff Country Reports 2017, 042; 10.5089/9781475575835.002.A001

Source: Haver Analytics.
A01ufig6

Share of Full-Time Jobs in Total Employment

(%)

Citation: IMF Staff Country Reports 2017, 042; 10.5089/9781475575835.002.A001

Source: Haver Analytics.

6. Both headline and core inflation have been below the inflation target range of 2-3 percent in 2016, and the Reserve Bank of Australia (RBA) responded promptly to an unexpected downshift in the inflation path. Initially, the disinflation that began in late 2014 had been driven by the declines in the prices of oil and other commodities. Over the past 12 months, however, the declines have been due to non-tradables inflation, with the RBA pointing to the temporary inflation impact from lower margins due to increased competition in the retail and other sectors. After a noticeable, unexpected decline of core inflation in the first quarter of 2016, and a downshift in the path of expected inflation, the RBA has lowered the policy rate by another 50 basis points to 1.5 percent in 2016 in May and August. Core inflation has since stabilized at around 1.6 percent. Wage growth has remained weak, with nominal unit labor costs running at less than 0.5 percent on average, and cost pressures have been virtually absent.

7. The current account balance has remained moderately weaker than its fundamental level and the Australian dollar has continued to be moderately overvalued. The commodity-currency adjustment mechanism that has come into play after the mining investment bust has supported the rebalancing of growth toward net exports, with investment weakness also weighing on imports. A renewed widening of the current account deficit in 2015 reflected temporary factors, including weather related export declines and exceptional imports, and the balance has since narrowed again. While currency depreciation in 2014-15 has reduced much of the overvaluation that had developed over the boom, the correction has stalled in recent months (Annex IV—External Sector Assessment). The latter has likely reflected the relative attractiveness of Australian assets, given their relatively high returns. Nonetheless, yields on longer-term Australian bonds have declined, and valuation effects from the resulting bond price increases, together with exchange rate appreciation, have contributed to a marked deterioration in the net external liability position over the past year, given the economy’s sizeable net short position in that asset class (Annex II). That said, the underlying risk profile has improved further, adding to improvements since the global financial crisis, as the share of longer-term external funding of Australian banks has increased over the past year or so, while that of short-term external funding has decreased.

8. By some metrics, housing market conditions have cooled and credit growth to households has slowed, but risks related to house price and debt levels have not yet decreased.

  • Realhousepricegainshavemoderated. Indicators of current conditions such as sales volumes and the rate of turnover in the housing stock have moderated. The extent of cooling has varied considerably across capital cities. The strongest price increases continue to be recorded in Sydney and Melbourne, where underlying demand for housing remains strong. With house prices still rising ahead of income, standard valuation metrics suggest somewhat higher house price overvaluation relative to the assessment in 2015 Article IV consultation.

  • Theflipsidehasbeenslowinggrowthinbanklendingtohouseholds. APRA prudential guidance requiring tighter lending standards by banks, which was introduced in late 2014, has curtailed growth in riskier mortgage loans in particular and credit growth to household more broadly. At the same time, there has been some upward pressures on mortgage rates, as banks have increased capital ratios and prepared for a higher risk weight on mortgage lending. That said, household credit gaps have not yet reversed.

  • Onthesupplyside, residential investment has risen to some 0.5 percent of GDP above its long-term average (the ratio remains comparatively low given population and labor force growth). An above-average number of new apartments is expected to come on stream in the next year or so, mostly in the downtown areas of Brisbane, Melbourne, and, to a lesser extent, Sydney. Concerns about temporary oversupply have thus risen. But leading indicators, such as approvals of new houses and other dwellings or new residential construction starts, have started to level off after brisk increases in 2014-15. In commercial real estate, property price valuations have increased but are still within the usual range of variation over the cycle (Box 1).

A01ufig7

New Residential Term Loan Approvals by Loan-to-Valuation Ratio (LVR)

(In percent of total new residential loans)

Citation: IMF Staff Country Reports 2017, 042; 10.5089/9781475575835.002.A001

Source: APRA
A01ufig8

New Residential Term Loans to Households Approved

(In percent of total new residential loans)

Citation: IMF Staff Country Reports 2017, 042; 10.5089/9781475575835.002.A001

Source: APRA

9. Household sector leverage has been stable overall despite higher debt, and debt buffers have risen but not for all households. The household debt ratio rose to 186 percent of gross disposable income over the past year, but underlying vulnerabilities have not increased to the same extent. Mortgage buffers—balances in related offset accounts and redraw facilities, which are held for tax and precautionary reasons—have also risen, to some 18 percent of outstanding mortgage loans by mid-2016—the equivalent of around 2½ years of scheduled debt payments at current interest rates. And household leverage (liabilities as a percent of net worth) has been stable and low at around 25 percent.3 Yet there is considerable heterogeneity across households. With house values a rising multiple of income, first-time homebuyers and other new borrowers tend to have higher debt ratios and smaller buffers. Indeed, around 25 percent of all households in each income quintile had debt to income ratios above 3 in FY2013-14—the latest available year for income and wealth data across households. These households may well be liquidity-constrained in an economic downturn.

A01ufig9

Household Leverage in the Flow of Funds

(%)

Citation: IMF Staff Country Reports 2017, 042; 10.5089/9781475575835.002.A001

Sources: Haver Anaytics and IMF staff estimates
A01ufig10

Household Leverage by Income Quantile

Citation: IMF Staff Country Reports 2017, 042; 10.5089/9781475575835.002.A001

Source: ABS.

10. Banks have further strengthened their balance sheets, responding to regulatory change and market pressure. The large Australian banks have raised the CET1 capital ratio from 8.6 of risk-weighted assets (RWA) in June 2014 to 10 percent at the end of 2015, partly through raising fresh capital, and the ratios are expected to have improved further in 2016. According to APRA studies, after adjusting for stricter requirements in capital and RWA calculations, these capital ratios have placed the banks at the low end of the top quartile internationally. Bank funding conditions have also improved, with foreign currency funding continuing to be fully hedged. Nonperforming loans (NPL) have remained largely unchanged.4

A01ufig11

CET1 Ratios of Major Banks

(% of RWA)

Citation: IMF Staff Country Reports 2017, 042; 10.5089/9781475575835.002.A001

B. Outlook

11. The baseline outlook is for the resumption of growth close to trend, a gradual return of inflation into the target range, and a slow stabilization of macro-financial vulnerabilities.

  • Growthisexpectedtobeclosetotrend, withincreasingcontributionsfromdomesticdemandgrowthastheadjustmenttothecommodityandminingshocksadvancesfurther. With the contraction in 2016Q3 largely due to one-off factors, growth is expected to resume in the last quarter of 2016. Residential investment growth is expected to rebound, given a strong pipeline of building approvals and housing starts. The contribution of private business investment to growth should turn positive, as the correction in mining investment should run its course and non-mining investment should start to pick up. In addition, states that have experienced rapid growth in activity are expected to ramp up infrastructure spending in 2017-18. Private consumption should strengthen with the recovery continuing and labor markets improving further. On the export side, the rate of growth is expected to slow somewhat, as the initial boost from new mining capacity and new sources of demand (e.g., tourism from Asia) should moderate.

  • Thedisinflationexperiencedin2015-16isexpectedtostartreversing. With the rebound of oil prices in 2016, an important source of disinflation has already dissipated. Other sources are expected to weaken gradually. The output gap is projected to decline, and the inflation effects from downward pressure on producer price levels from increased competition in the retail sectors should wear off with no major new market entrants.

  • Themacro-financialoutlookisforastabilizationofhousing-relatedvulnerabilities. The main driver is a realignment of house price inflation with broader measures of inflation and robust growth. Recent increases in residential investment should result in higher supply over the next two years, especially in market segments that have seen higher prices increases, and lower affordability should constrain demand. Credit gaps and debt ratios should thus stabilize or decline. On the external side, the accumulation of net external liabilities should slow in the absence of valuation effects. As banks prepare to meet net stable funding ratio requirements by 2018, related vulnerabilities should improve further.

C. Risks

12. The balance of risks has improved but is still to the downside. The interaction of external and domestic downside risks must remain the main policy concern. The momentum of the recovery could be stronger, as recent terms-of-trade improvements could boost business confidence and commodity production if they are more persistent than expected. On the downside, growth could be slower, as consumption growth could remain lackluster with continued low wage growth and high incidence of part-time work, and profits could remain under pressure for longer with increased competition and relatively persistent slack. On the external side, there are risks to global trade from rising populism and nationalism in large economies and from tighter and more volatile global financial conditions. A major concern for macro-financial risk management is that external risks could hit both traditionally exposed sectors (commodity prices and exports) and new sources of growth (e.g., services exports), for example, a sharper growth slowdown in China (Annex V—Risk Assessment Matrix). If such external risks materialized, they could interact with or even trigger domestic risks, especially a sharp housing market correction, also given that annual approvals for all non-residents applying to purchase residential property have substantially increased to around 20 percent of overall turnover value, and they could lead to external funding pressure for banks.

D. The Authorities' Views on Outlook and Risks

13. The authorities emphasized that the transition to non-mining-based growth after the boom was well advanced. They acknowledged that some elements of the “new mediocre” were present, including weak private business investment. But they saw these as a reflection of the drawn out adjustment of the economy to the decline in the terms of trade and the large fall in mining investment rather than a cause. While many of the new jobs were part-time ones, this partly reflected preferences in the labor force. The rise in underemployment as well as in long-term and youth unemployment had remained small in historical comparison, and growth in output had remained close to trend. And while trend growth was lower, the decline was small, about a quarter of a percentage point, partly reflecting lower population growth, not lower capital intensity or productivity growth.

14. Robust broad-based growth was expected to continue. The authorities noted that the unexpected decline in GDP in the September quarter of 2016 was partly a result of falling mining investment and a series of one-off factors including weather-related falls in non-residential construction and dwelling investment. Looking forward, economic growth would be supported by household consumption; another wave of LNG capacity was expected to ramp up, in 2017 as well as in 2018; public investment growth would rise as States’ infrastructure spending was budgeted to increase further; residential dwelling investment growth, while moderating, would remain strong in the near term; and private business investment would no longer detract from growth in 2018 as the drag from mining investment would ease and non-mining investment would rise moderately. GDP growth would strengthen to around trend rates. The authorities indicated that the economy would thus return to full employment gradually, with underemployment declining and inflation moving back into the target range. While the balance of risks had improved, it remained tilted to the downside, with the possibility of a hard landing in China being a key medium-term concern.

15. The authorities noted that risks associated with high and rising household leverage had diminished. Tighter bank lending standards, encouraged by prudential measures, had led to slower mortgage credit growth, with improved risks profiles for new loans, and a moderation in housing price growth. Risks related to short-term demand-supply mismatches in housing markets were localized. There were some risks related to lending to real estate developers but those were being closely monitored. Households across all income brackets continue to accumulate deposits in offset accounts, implying that effective household debt was lower, and did not use mortgage borrowing to finance consumption. More resilient bank balance sheets were another factor contributing to diminished housing risks.

Economic Policy Priorities

16. Discussions focused on policy requirements to meet three broad objectives: Completing the economy’s transition to non-mining growth; containing macro-financial vulnerabilities; and enhancing longer-term growth potential.

A. Supporting Aggregate Demand

Context

17. Australia’s transition to non-mining-based growth has advanced significantly with monetary policy support but the process is not completed. The lack of significant price and wage pressures suggests that some economic slack is still present, which, if prolonged in what has already been a drawn-out adjustment process, risks hurting medium-term supply potential.

18. The RBA cut the policy rate promptly in response to the unexpected downshift in the expected inflation path in early 2016. The easing also helped to realign the policy rate with interest rates elsewhere, which had declined in some other major advanced economies through September 2016. Staff background work suggests that the equilibrium real interest rate has declined from about 3 percent in the early 1990s to close to 1 percent in the second quarter of 2016 compared to an actual real rate of 0.2 percent, although there is substantial uncertainty around such estimates.5 Absent monetary easing, upward pressure on the Australian dollar would likely have been stronger, reinforcing the disinflationary impulse experienced early in the year.

19. Australia has substantial fiscal space. Standard metrics suggest that Australia has fiscal space under both the baseline and economic stress scenarios (Annex VI—External and Fiscal Debt Sustainability Analysis). For example, sovereign spreads over U.S. bonds have been relatively moderate in the past 12 months (at most 64 basis points); gross debt is still low at 40 percent of GDP compared with other major advanced economies.

20. The federal government has recently aimed for substantial near-term fiscal consolidation but budget targets have not been met because of weaker nominal income. Automatic stabilizers have been allowed to operate in response to weaker growth and lower inflation, and the fiscal stance in 2016 is estimated to have been broadly neutral. Against this backdrop, concerns about recent public debt increases and what they mean for Australia’s top-ranked sovereign debt rating have dominated fiscal policy discussions.

21. In the FY2016/17 budget, the government has projected a return to fiscal balance by FY2020/21. It has also renewed its commitment to a federal government surplus of 1 percent of GDP over the business cycle as a medium-term fiscal anchor, which would imply a cumulative adjustment of up to 3.4 percent of GDP. The Mid-Year Economic and Fiscal Outlook 2016-17 (MYEFO), released on December 19, 2016 foresees a cumulative adjustment of the fiscal balance of 2.1 percent of GDP by end of FY2019/20, as revenues strengthen in line with the economy, primarily related to stronger personal income tax collection because of bracket creep.

Staff Views

22. The RBA’s monetary policy stance should remain accommodative until the return of inflation to the mid-point of the target range is highly secured. Australia has not experienced the persistent low inflation problem of other advanced economies, and medium-term inflation expectations, while lower, have generally remained within the target range. But with economic slack expected to decline only gradually and taking into account downside risks, policy decisions should remain predicated on the possibility that the return of inflation back to target may take longer, consistent with recent international experience. And in current circumstances, there are asymmetric costs to inflation risks, given policy objectives. The risk of inflation rising faster than expected is less costly than risks of inflation being lower. Monetary policy can likely respond more effectively to positive surprises for some time, given that from current policy settings, policy rates may rapidly reach the effective lower bound if negative surprises reflect large shocks to demand.

23. The RBA could consider enhancing its policy communication given the inflation outlook and the risk of hitting the effective lower bound under a downside scenario. While increases of longer-term interest rates in advanced economies since October are suggestive of some increase in underlying equilibrium interest rates, policy rates in Australia may well stay low for some time. Under these conditions, risks of low inflation becoming entrenched could be reduced through clear guidance by the RBA on the horizon over which inflation is expected to return to the mid-point of the target range and on the likely policy measures should downside risks materialize. To lay the foundation, the RBA could consider lengthening the forecast horizon in its Statements on Monetary Policy. More clarity on the policy rate path, possibly through publication of the RBA’s projected policy rate path, could also enhance the RBA’s communication with markets and price setters.

24. The government should use its fiscal space for a gradual fiscal consolidation and structural fiscal reform. The conditions calling for more pro-active fiscal stimulus, including policy rates at the effective lower bound and impaired monetary policy transmission, are not present. Some fiscal consolidation remains desirable—not the least in view of a sizeable structural budget deficit and impending medium-term increases in ageing-related spending. However, Australia has the fiscal space to undertake budget repair gradually. Any remaining negative demand effects could be offset by continuing accommodative monetary policy, expenditure switching, and growth-friendly structural fiscal reform. In contrast, a front-loaded fiscal consolidation based on measures would pose too much of a risk to the on-going recovery. The MYEFO 2016-17 shows a fiscal improvement based on an economic recovery, broadly consistent with staff’s views on growth in the coming years.

25. Structural fiscal reform should focus on supporting growth through increased spending on infrastructure, innovation, labor market integration, and tax reform.

  • Thereisroomforgreaterinfrastructureinvestment. While general government spending on infrastructure has increased in FY2016/17, this increase primarily reflects higher spending by States, not the Commonwealth. Indeed, capital spending is expected to increase by ½ of a percentage point of GDP in the current budget year, but these efforts are not expected to be sustained as spending is projected to level off in the next fiscal year and to decline thereafter. A more sustained, multi-year increase in spending on efficient infrastructure also at the Commonwealth level would be desirable, considering that Australia has infrastructure needs and fiscal space and the funding environment is favorable.

  • Reformsthatsupportinnovationandproductivityshouldbestrengthened. These would include an upgrade of the R&D tax credits put in place last year and active labor market policies, to lower risks of hysteresis in labor markets and support human capital formation in an environment of rapid structural change, increased part-time employment, and higher long-term unemployment.

  • Ataxshift, loweringcorporateandhouseholdincometaxeswhileincreasingthegoodsandservicestax(GST), couldboostinvestmentandliftGDP. Background work using the IMF’s G20MOD suggests that in Australia, the long-term multipliers for a 1 percent of GDP shift from corporate income taxes to the GST is roughly 0.6 percent of GDP, while that of labor income taxes to the GST is over 0.1 percent of GDP. A revenue-neutral tax shift should thus lead to a permanent increase in the level of real GDP. 6

26. Should downside risks materialize, fiscal stimulus may be needed to boost aggregate demand, as monetary policy may rapidly be constrained by the effective lower bound. If the shock is large, an effective macroeconomic policy response may well require expansionary fiscal policy. In a China downside scenario, model-based scenario analysis in background work by staff illustrates how a combined monetary and fiscal policy response ensures a faster recovery (Box 2). With some high-impact downside risks to the near- and medium-term outlook present, contingency plans for expansionary fiscal policy should be prepared, given the implementation lags involved in undertaking fiscal stimulus. Such contingency plans should include a revolving pipeline of ready-to-implement infrastructure projects, with coordination between the Commonwealth and State governments.

27. An IMF staff review of the fiscal anchor and framework suggests that the authorities consider changing to a long-term debt anchor.7 In 2010, the government raised the mediumterm anchor from a zero balance to a surplus of 1 percent, with a view to reverse the recent debt accumulation. In staff’s view, it is a strength of Australia’s fiscal framework that it requires governments to report against a medium-term fiscal strategy based on “principles of sound fiscal management.” But the authorities should consider replacing the current medium-term budget balance anchor with a longer-term debt anchor. The latter would provide certainty about debt and fiscal policy in the future. Once in place, the debt anchor would encourage the government to discuss the implication of unanticipated shocks on the fiscal position and the medium-term fiscal strategy. At the same time, if implemented over a 5- to 10-year horizon, the framework would remain sufficiently flexible to allow for countercyclical fiscal policy support if needed.

Authorities' Views

28. The RBA was concerned about the potential costs to financial stability from further monetary easing relative to the benefits of inflation returning to target faster. Against expectations of robust growth and improving labor markets, it considered risks of inflation becoming entrenched below target to be low. The undershooting of core inflation was recent. But the RBA was ready to ease further should the outlook for labor markets and inflation deteriorate materially. RBA officials saw costs and benefits to changing policy communication strategies. While RBA staff were working on extending the forecast horizon, they were concerned that conditional forecasts of the policy rate path could be misread as RBA commitment. RBA officials noted that they could use unconventional monetary policy measures should the need arise, with circumstances dictating the instruments to be used. However, they considered the risks of reaching the effective lower bound for policy rates to be low, partly because the Australian dollar usually depreciated in the case of adverse external shocks. This, in turn, could ease the burden on monetary policy in responding to a downturn.

29. The authorities were less sanguine than staff about the extent of available fiscal space and did not think that current circumstances required its active use. They noted concerns by rating agencies about the sizeable and persistent budget deficits and emphasized that being a capital importing country, which generally runs current account deficits, requires greater fiscal prudence than otherwise. In their view, the economy could absorb the proposed path of fiscal consolidation, noting that much of the expected increase in revenue was through household income tax bracket creep, rather than measures with higher multipliers. However, they agreed that, in the face of negative economic shocks, such as a sharp slowdown in China, increased fiscal spending would need to be considered, as the effectiveness of monetary easing might be diminished. Concerns about a widening current account deficit could be mitigated if it is driven by fiscal spending that encourages stronger domestic investment instead of only weakening saving ratios.

30. The authorities felt that the composition of fiscal adjustment was as important as the pace of consolidation. In this respect, they noted that past spending increases often focused on recurrent spending. Some of the spending had not been productive, while other spending could be reduced while maintaining or improving outcomes through increased productivity in the delivery of services. Restraining recurrent spending would help in increasing productive spending, on infrastructure investment, nurturing innovation, and on measures encouraging private investment, real wages and incomes in the private sector. This in turn would help on the revenue side as well, particularly for healthy labor income tax revenues, which depend on growth to induce bracket creep.

B. Managing Macro-Financial Vulnerabilities

Context

31. Momentum in house prices and housing credit has moderated and bank balance sheets have strengthened with prudential and regulatory steps, but vulnerabilities have not yet decreased materially. Intrinsic housing market risks have become more localized. The escalation of APRA’s supervisory intensity, including guidance on lending standards, over the past year and a half has contributed to lowering growth in new, higher risk lending (e.g., with loan-to-value ratios of more than 80 percent), while housing market conditions have cooled broadly. Nevertheless, risks of renewed price acceleration remain, as mortgage and interest rates more broadly are still low, while foreign investment interest in residential property in the major cities continues to be strong. And high household debt could still amplify the negative impact of large shocks. Regulatory steps under the Basel III framework have contributed to banks’ stronger capital positions. As of January 2016, banks had to meet a capital conservation buffer of 2.5 percent of RWA, and a buffer for domestic systemically important institutions of 1 percent of RWA became effective. The counter-cyclical capital buffer is currently set at zero. In addition, in July 2016, a floor for mortgage risk weights for banks using the IRB approach took effect. Tighter prudential rules do not seem to have led to migration of credit activity to non-banks, and the shadow banking sector in Australia has remained relatively small over recent years.

Staff Views

32. With signs of a cooling housing market, the tightening of prudential measures should remain a contingency. Under the IMF staff’s macro-financial baseline outlook, tighter loan restrictions could accelerate a cooling in housing market, which would be pro-cyclical. In markets where a house price correction has already begun—in the mining states, for example—they risk delaying the recovery from the commodity bust, including by hindering labor mobility. But with continued upside risks to house prices and housing lending growth, APRA should stand ready with targeted prudential measures. Minimum amortization requirements for new loans could also be considered to rein interest-only lending further.

33. Banks’ should further strengthen their capital position, which would increase their resilience to housing and other macro-financial shocks. This approach would focus on strengthening banks’ ability to absorb losses from a more significant housing market correction. For instance, APRA could consider adjustments to the level of required capital, dependent on banks’ exposure to risky housing market segments and lending standards in those segments (pillar 2 adjustments). Alternatively, it could consider introducing higher minimum risk weights for some lending, notably higher-risk housing-related loans. With expectations of lower profitability in the sector, it will be important for banks to remain in a position to continue to generate sufficient internal capital to finance the growth of their balance sheets and maintain unquestionably strong capital ratios.

34. In the longer term, the macro-financial resilience of the economy to housing market shocks could be enhanced through tax reform. The Commonwealth tax system provides households with incentives for leveraged real estate investment that likely amplifies housing cycles. The incentives arise from the combination of tax concessions on capital gains and the possibility to apply losses from negative gearing to income from other sources. Reforms of capital gain tax concessions would need to be undertaken in a broader context, to avoid introducing new distortions in the taxation of different assets.

35. Broader progress in implementing the regulatory reform agenda would also help in lowering and managing financial sector risks. APRA’s efforts to develop an operational framework to assess whether Australian banks are “unquestionable strong” in international comparison will further reduce bank-related financial stability risks. Another priority are reforms recommended in the 2014 Financial Sector Inquiry for increasing the resilience of the banking system, such as the implementation of a framework for loss absorbing and recapitalization capacity and the introduction of a leverage ratio, in the context of international regulatory developments.

36. The authorities are taking steps to address the lack of adequate AML/CFT safeguards in the real estate sector. In 2015, the Mutual Evaluation Report of Australia’s AML/CFT regime by the Financial Action Task Force found that the real estate sector is exposed to significant money laundering risk and should be subject to AML/CFT safeguards in line with the international standards. In response, Australia has recently completed a statutory review of its AML/CFT regime and initiated a consultation process about regulating real estate professionals under the AML/CFT Act._The cost-benefit analysis of different regulatory models is expected to be completed by July 2017.

37. Remittance flows from Australia have remained broadly stable while regional correspondent banking relationships with Australian banks have continued. AUSTRAC’s tracking of international funds flowing through financial intermediaries registered in Australia suggests no significant change in patterns or magnitudes of remittance flows. That said, money transfer operators have been subject to structural change, given evolving financial technology, and regulatory change. While some operators have had their bank accounts closed, this has only affected a subset among them. However, money transfer operators have faced increased costs and complexities of doing business. At this stage, there is no evidence that Australian banks have stopped correspondent banking and other business with neighboring Pacific Islands. Nevertheless, recognizing the potential for negative spillovers, the authorities have formed a high-level interdepartmental committee to coordinate policies, intensified consultation with the industry, provided neighboring countries with technical assistance to deal with AML/CFT challenges, and actively engaged in the G20 Global Partnership for Financial Inclusion.

Authorities' Views

38. The authorities concurred that policies should focus on further strengthening resilience to housing market and other shocks with macro-financial implication. Regarding “unquestionably strong” capital ratio of banks, APRA stressed that a top quartile positioning relative to international peers is only one guidepost and that other benchmarks would be used as well. For example, capital positions against rating agency measures of capital strength would be assessed and the result of stress tests can also be informative. In terms of timing, APRA did not expect that final standards on unquestionably strong capital ratio would be released soon, given that 2017 will be a year of consultation. The standards would be unlikely to take effect until at least a year after that to facilitate an orderly build-up of capital. APRA indicated openness to the use of a range of prudential measures in case they are needed.

39. The Treasury continues its efforts to introduce new legislation to deliver on the Government’s financial system agenda. In its response to the recommendations of the Financial System Inquiry (FSI), the government announced 48 measures, including on the crisis management toolkit, banks resolution, and consumer protection, which require legislation to be prepared and worked through the legislative process.

C. Keeping Up Productivity Growth

40. Maintaining high productivity growth rates may be challenging. Aggregate labor productivity growth in Australia has remained stable over the past decade and a half, increasing at an annual average rate of around 1.5 percent. More recently, however, labor productivity growth has slowed, with weaker multifactor productivity especially in the services sectors, which have accounted for most of the growth in employment since the end of the mining boom. At the same time, weak non-mining investment has likely resulted in less capital deepening.

41. Moving ahead with a range of smaller reforms may nevertheless boost productivity. After a wave of reforms in the early 1990s, there are few low-hanging fruit in terms of large-scale structural policies. Australia generally ranks favorably compared to other OECD countries in key “ease of doing business” areas, although its relatively favorable position has eroded over time as other countries have also improved and progress on reforms in Australia has slowed. Policy priorities have been identified in commissioned expert Reviews and Inquiries, while the Productivity Commission provides the government with research and analysis. The reform agenda, including on the tax side, has been shaped by the 2015 Competition Policy Review (“Harper Review”) and the 2014 Financial System Inquiry (“Murray Inquiry”).

Staff Views

42. Recent structural reforms have appropriately focused on fostering innovation. Innovation is key to factor productivity growth, but there are sizeable gaps relative to the frontier in this dimension. Investment in knowledge capital is relatively low in Australia, partly reflecting low R&D spending relative to other advanced economies. The government’s National Innovation and Science Agenda (NISA) allocates $1.1 billion (less than 0.1 percent of GDP) over four years to boost innovation and entrepreneurship in the high-tech sector, including through tax breaks. Recognizing the difficulties in fostering innovation through policies, the authorities are closely monitoring outcomes to ensure policy effectiveness. The government plans to continue and expand the program if it proves to be effective.

43. Product market reforms can be expanded in targeted areas. The Harper Review has identified a number of reforms to boost competition and productivity in the services sectors, and to strengthen competition policy broadly. Some of the major benefits from the proposed measures arise from reforms to increase competition in the delivery of human services on behalf of governments, and in other markets including construction, retail trade, and transport. A number of these reforms will have to be implemented at the state level, which will require complex coordination between the Commonwealth and State governments, in legislation and through intergovernmental agreements. Legislation for key components are still under preparation, and efforts to expedite implementation of the Harper Review would be beneficial. In addition, efforts to increase competition in the financial sector, including through implementation of measures identified in the Murray Inquiry, should continue.

44. Trade liberalization is another means to increase competition and Australia intends to continue efforts towards further liberalization in regional and multilateral fora. Aside from benefiting from traditional lines of exports, Australia would also stand to gain from enhanced access to service export markets, which would also serve to strengthen service sector productivity in Australia. At the same time, active labor market policies and the social safety net would help to mitigate the cost to those who would bear the burden of adjustment.

45. Tax reforms appear challenging in the current political environment. The government managed to achieve passage of a tax cut for small business in the current Budget, but has yet to introduce similar measures for larger firms. Such a measure should be part of a package of broader reforms that remains to be accomplished, including reducing tax concessions, and the shift in the tax mix discussed above as part of structural fiscal reforms. Such reforms could enhance productivity.

46. Labor markets have performed well. The flexible labor market settings have contributed to a smooth adjustment from the mining boom with low unemployment. However, the elevated rate of underemployment, and persistent youth unemployment could lead to diminished incentives to accumulate human capital if not addressed. While the gradual elimination of economic slack should help to ease some of the potential for problems, the authorities should remain vigilant to prevent deepening skill mismatches and labor market hysteresis. In this context, the government’s $840 million Youth Employment Package, which seeks to increase employability of youth mainly through wage subsidies, is a welcome step.

Authorities' Views

47. The authorities agreed that the productivity growth environment is challenging. While labor productivity growth has been stable, it is expected to grow at a somewhat slower rate over the next few years. Moreover, half the aggregate labor productivity growth recorded recently was contributed by the mining sector, which has moved to the less labor-intensive production phase after a long investment phase.

48. The authorities aimed to improve productivity through targeted steps, with legislative steps under preparation. With key economy-wide reforms already implemented, future productivity gains would require specific measures, which include increasing contestability in markets for services, and boosting innovation capacity and absorption. Reforms identified in the Harper Review would primarily have to be implemented at the state level, and would require close coordination between the Commonwealth and State governments. The government is finalizing intergovernmental agreements and National Partnerships detailing funding for measures taken at the state level. These Partnerships are expected to be formed by mid-2017 to mid-2018. Other reforms proposed in the Harper Review can be implemented by the Commonwealth government and may be introduced as early as mid-2017.

49. Innovation was emphasized as a priority. The government’s NISA would help to boost innovation capacity by seeking to encourage entrepreneurship, and to enhance industry-science collaboration. Future waves of NISA would envisage building science capability in niche areas such as health or data analytics, encouraging private sector investment in innovation and making it easier for business to interact with Government.

50. The authorities were pressing ahead with trade liberalization. They were committed to the passage of the TPP. Even if it were not to come into force because some other signatories may not pass it, the authorities were committed to implementing as many of its provisions as possible by other means such as bilateral agreements - for example, the recent expansion of its 2003 free trade agreement with Singapore. They were also interested in continuing negotiations for the RCEP (Regional Comprehensive Economic Partnership), which includes China and the Asia-Pacific TPP signatories.

Staff Appraisal

51. Context. Australia has experienced robust growth and low unemployment during the drawn-out adjustment to the commodity price and mining investment bust, highlighting the resilience of the economy and strong policy frameworks. But it has not been immune to symptoms of the “new mediocre.” Wage and price pressures have been weak, underemployment has risen, and private business investment outside mining has been lackluster.

52. Outlook and risks. After a growth pickup from mid-2015, real GDP unexpectedly contracted in 2016Q3, largely on account of one-off factors, so growth close to trend is expected to resume. The balance of risks to the growth outlook improved in 2016 but remains tilted to the downside. While recent terms-of-trade improvements provide for some upside, domestic demand could remain lackluster with continued weak wage growth and underemployment. A major concern is that high-impact external risks could interact with or even trigger domestic risks, especially a housing correction.

53. On the macro-financial side, prudential policies have contributed to a tentative stabilization of housing-related and external vulnerabilities. APRA’s prudential measures introduced in late 2014 have improved the risk profile of new loans. While household debt has remained high, risks to banks and to household balance sheets have been mitigated by the strong growth in mortgage buffers. The macro-financial risk outlook has also improved as banks’ balance sheets have become more resilient with higher capital ratios and a higher share of stable funding.

54. The economic policy agenda should center on three priorities: Demand support to ensure completion of the transition to non-mining-based growth; further reductions in macro-financial vulnerabilities, and reforms to enhance the longer-term growth potential.

55. The monetary policy stance should remain accommodative. Australia’s low inflation is more recent, but policy decisions should remain predicated on the possibility that inflation may return into the target range later than expected, given international experience. Prudential measures to address housing-related risks have mitigated risks to balance sheets and financial stability from lower policy rates.

56. Australia still has substantial fiscal space despite recent public debt increases, which allows for a gradual approach to fiscal consolidation and higher growth-friendly spending.

  • Thegovernmentappropriatelyplanstobalancethebudgetoverfouryears, whilemakingtheexpenditurecompositionmoregrowth-friendly. Efforts focus on supporting longer-term inclusive growth, including by boosting innovation and tax reform.

  • Theenvisagedfiscalconsolidationrisksbeingtoofront-loaded. Over the next two years, the budget targets reductions in the structural budget deficit of close to 1½ percent. This ambitious pace risks being counterproductive in the current phase of the recovery, especially if it does not provide for the increases in productive spending needed to support longerterm growth.

  • Amoresustainedpublicinvestmenteffort. A multi-year increase in spending on efficient infrastructure beyond the planned current short-lived increase would be desirable, considering that Australia has infrastructure needs and fiscal space.

57. If high-impact downside risks were to materialize, fiscal policy should support aggregate demand, as monetary policy could be constrained by the effective lower bound. Developing contingency plans and a pipeline of infrastructure projects would help reduce implementation lags in undertaking fiscal stimulus.

58. With more acute risks concentrated in a few specific housing market segments, policies should focus on further strengthening resilience to housing market and other shocks with macro-financial implications.

  • ➢ With continued upside risks to house prices, APRA should stand ready to intensify targeted prudential measures, if lending or house price growth were to re-accelerate.

  • ➢ APRA should continue to actively encourage banks’ efforts to robustly anchor their capital position in “unquestionably strong” territory, given a highly concentrated banking sector where banks have similar business models.

  • ➢ Treasury’s preparation of new legislation to further the regulatory reform agenda should continue to complete the implementation of the FSI recommendations. APRA should continue in its effort to implement prudential steps to strengthen the loss absorbing and recapitalization capacity of banks and introduce leverage ratios, in line with the international agenda.

59. The government’s structural reform agenda appropriately focuses on fostering innovation and strengthening competition, and the intention to push for trade liberalization is welcome. The NISA, is an important step forward. The efforts should continue, as currently envisaged, and, if effective, be expanded. The measures recommended by the Harper Review would strengthen services sector competition and productivity, but implementation will require determined effort. Expanding access to service export markets could also strengthen services sector productivity in Australia and elsewhere, while the social safety net and active labor market policies could mitigate the cost to those who bear the burden of adjustment.

60. It is recommended that the next Article IV consultation be held on the standard 12-month cycle.

Developments in Australia’s Commercial Real Estate Market

Signs of commercial real estate overvaluation have emerged. Commercial real estate (CRE) prices in Australia have increased rapidly since mid-2014. Rents have not followed at the same pace, and the price-to-rent (PR) ratio is now above average. Whether the latter is a good metric of fair value is difficult to assess. But the deviations from average are now close to levels last seen before the global financial crisis. Shortly thereafter, there was a sharp correction in CRE prices in the context of the crisis. Internationally, Australia’s CRE PR ratio is closer to the pre-crisis maximum than in almost all other countries for which data are available, with the notable exception of the United States and Canada. The valuation increases may in part reflect the strong interest of foreign investors in Australian CRE assets.

A01ufig12

Price to Rent Ratio

(%)

Citation: IMF Staff Country Reports 2017, 042; 10.5089/9781475575835.002.A001

Sources: MSCI; and IMF staff calculations.
A01ufig13

Price to Rent Ratio

(% deviation from historical mean, max and min during 2006Q1 to 2016Q1)

Citation: IMF Staff Country Reports 2017, 042; 10.5089/9781475575835.002.A001

Sources: MSCI; and IMF staff calculations.
A01ufig14

Approvals by Country of Investor on Real Estate in 2014-2015

(In millions of AUD)

Citation: IMF Staff Country Reports 2017, 042; 10.5089/9781475575835.002.A001

Risks to financial stability from any potential CRE overvaluation appear manageable. The share of CRE lending in commercial banks’ total assets decreased in the past few years and has now stabilized at around 5 percent. Even so, banks’ lending growth to CRE has been rising recently, with increased contribution by Australian branches of foreign banks. The share of impaired CRE assets over total CRE assets has declined and the impaired assets are almost fully provisioned. While a downturn in the CRE market would likely not pose a major financial stability risk, it may still have important macroeconomic effects as Australia’s CRE capital expenditures as a percent of GDP are relatively high in comparison.

A01ufig15

CRE Lending Growth Rate

(yoy, %)

Citation: IMF Staff Country Reports 2017, 042; 10.5089/9781475575835.002.A001

Source: APRA.
A01ufig16

Share of CRE

(% of Banks’ Total Asset)

Citation: IMF Staff Country Reports 2017, 042; 10.5089/9781475575835.002.A001

Source: APRA.
A01ufig17

Impaired CRE Assets and Special Provisions

(%)

Citation: IMF Staff Country Reports 2017, 042; 10.5089/9781475575835.002.A001

Source: APRA.
A01ufig18

Share of CRE Related Capital Expenditure

(% of GDP)

Citation: IMF Staff Country Reports 2017, 042; 10.5089/9781475575835.002.A001

Sources: MSCI; Haver Analytics; and IMF staff calculations.

A China Downside Scenario with Monetary and Fiscal Policy Responses

Disappointing external environment may require a ‘low for longer’ strategy for monetary policy. We consider alternative simulations where China’s economic growth surprises on the downside. This has significant spillover effects on the rest of the world and a sizable impact on commodity prices. This downside scenario implies an opening up of the effective foreign output gap relevant for the Australian economy (defined as export-weighted output gaps for Australia’s main trading partners). Specifically, the effective foreign output gap is 2.3 percentage points lower and metal prices are 5.3 percent lower at the trough compared to the baseline. Under the blue line, in anticipation of the negative shocks, the policy rate declines to the effective lower bound (assumed to be 0.75 percent) and stays there for 2 years. This results in a further depreciation in the Australian dollar that helps support the economy. However, a sizable negative output gap remains for the Australian economy as largely dominated by the magnitude of the negative shock. Headline inflation slightly overshoots the 2.5 percent mid-point of the RBA’s 2-3 percent inflation target range.

A combined monetary-fiscal policy would provide a much-needed shot in the arm for the Australian economy if the downside shocks were to materialize. Under this case, a direct fiscal stimulus is used to help deal with the negative external shocks hitting the Australian economy. The direct effects of the fiscal stimulus are equal to 0.25 percent of GDP for 2017-18. Monetary policy provides the ‘supporting role’ to a much-welcomed fiscal expansion by cutting the policy rate aggressively to its lower bound faster than under the previous case. This helps raise inflation and generate a modest overshoot of inflation above the upper bound of the 2-3 percent target range over the medium term. This planned overshoot of inflation raises inflation expectations and reduces the real interest rates, which combined with more depreciated exchange rate helps close the output gap much faster. A faster recovery of the economy under this more accommodative strategy allows monetary policy to renormalize earlier than under the previous case.

A01ufig19

Policy Rate

(%, p.a.)

Citation: IMF Staff Country Reports 2017, 042; 10.5089/9781475575835.002.A001

A01ufig20

Output Gap

(%)

Citation: IMF Staff Country Reports 2017, 042; 10.5089/9781475575835.002.A001

A01ufig21

Exchange Rate

(AUD per 1 USD)

Citation: IMF Staff Country Reports 2017, 042; 10.5089/9781475575835.002.A001

A01ufig22

Headline Inflation

(%, Y/Y)

Citation: IMF Staff Country Reports 2017, 042; 10.5089/9781475575835.002.A001

Figure 1.
Figure 1.

Australia in International Comparison

Citation: IMF Staff Country Reports 2017, 042; 10.5089/9781475575835.002.A001

Source: IMF, World Economic Outlook database.
Figure 2.
Figure 2.

Strong Advances in the Recovery from the Mining Bust

Citation: IMF Staff Country Reports 2017, 042; 10.5089/9781475575835.002.A001

Sources: Haver Analytics; dxTime; ABS; and IMF staff calculations.
Figure 3.
Figure 3.

Current Account Improving After Rebalancing Toward Net Exports

Citation: IMF Staff Country Reports 2017, 042; 10.5089/9781475575835.002.A001

Sources: Haver; IMF, World Economic Outlook; ABS; RBA; and IMF staff calculations.
Figure 4.
Figure 4.

Housing Risks Remain

Citation: IMF Staff Country Reports 2017, 042; 10.5089/9781475575835.002.A001

Sources: OECD; RBA; APRA; RBNZ; Corelogic; BIS;Haver Analytics; and IMF staff calculations.
Figure 5.
Figure 5.

Monetary Policy Faces a Disinflationary Impulse

Citation: IMF Staff Country Reports 2017, 042; 10.5089/9781475575835.002.A001

Sources: RBA; Haver Analytics; and IMF staff estimates.
Figure 6.
Figure 6.

Strong but Deteriorating Public Finances

Citation: IMF Staff Country Reports 2017, 042; 10.5089/9781475575835.002.A001

Sources: Commonwealth and State/Territory Treasuries; 2016-17 Budget; IMF, World Economic Outlook and IMF staff estimates and projections.
Figure 7.
Figure 7.

Banking System Remains Strong

Citation: IMF Staff Country Reports 2017, 042; 10.5089/9781475575835.002.A001

Sources: Bankscope; RBA; APRA; Financial Soundness Indicators; and IMF staff calculations.
Figure 8.
Figure 8.

Financial Market Indicators: New Lows for Yields and Spreads

Citation: IMF Staff Country Reports 2017, 042; 10.5089/9781475575835.002.A001

Sources: Bloomberg; RBA; and IMF staff calculations.
Figure 9.
Figure 9.

Interconnections and Spillovers

Citation: IMF Staff Country Reports 2017, 042; 10.5089/9781475575835.002.A001

Sources: ABS; APRA; RBA; IMF, Direction of Trade Statistics; BIS; and IMF staff calculations.
Table 1.

Australia: Main Economic Indicators, 2012-2022

(Annual percent change, unless otherwise indicated)

article image
Sources: Authorities' data; IMF World Economic Outlook database; and IMF staff estimates and projections.

Reflects the national accounts measure of household debt, including to the financial sector, state and federal governments and foreign overseas banks and governments. It also includes other accounts payable to these sectors and a range of other smaller entities including pension funds.

Calendar year.

Table 2.

Australia: Fiscal Account, 2012/13-2021/22

(In percent of GDP, unless otherwise indicated)

article image
Sources: Authorities' data and IMF staff estimates and projections.

Accrual basis; GFS. Comprises the Commonwealth, and state, territory, and local goverments.

Includes Future Fund assets.

Excludes general revenue assistance to states and territories from revenue and expenditure.

Excludes Commonwealth payments for specific purposes from revenue and expenditure.

Table 3.

Australia: Balance of Payments, 2012-2022

(In percent of GDP, unless otherwise indicated)

article image
Sources: Authorities' data and IMF staff estimates and projections.